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By Jeremy Glaser | 05-07-2014 03:00 PM

Moats Great Indicators for Stock Staying Power

Companies with fortified moats can stave off competition and tend to have better risk-adjusted returns than the broader market.

Securities mentioned in this video
EBAY eBay Inc

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The concept of economic moats has been used successfully by a number of well-known investors. I'm here today with Elizabeth Collins and Heather Brilliant. They're co-authors of the new Morningstar book, Why Moats Matter, to look at this concept and how investors can profit from it.

Elizabeth, Heather, thanks for joining me.

Heather Brilliant:  Thanks for having us, Jeremy.

Glaser: Like we mentioned a lot of investors, including Warren Buffett, have used this concept of economic moats. What drew you to this concept, and how do you really think about it? How do you define economic moats?

Brilliant: Morningstar has been researching economic moats for more than a decade now, and we really have tried to find companies with sustainable competitive advantages. And I'll let Elizabeth go into a little bit more of the detail behind how we think about economic moats. But in a nutshell, we're looking for companies that have staying power and that can really stave off competition.

Glaser: Elizabeth, what is that process? How do you find these companies?

Elizabeth Collins: We're looking for two things. First is we want to find companies that are currently or will in the future generate economic profits or returns on invested capital that exceed the weighted average cost of capital. But we're also looking for qualitative things, these sustainable competitive advantages that can come in a handful of ways. Things like cost advantages, intangible assets, network effect, efficient scale--these are the things we are looking for.

Glaser: What's the advantage of using this lens? What do you gain from it?

Collins: What we find is that companies that have narrow, and more importantly, wide economic moats or the ability to generate economic profits for 20 or more years into the future, these companies tend to have better risk-adjusted returns than the market as a whole.

Glaser: Are there any downsides to economic moat analysis? Are you missing out on the future growth stories?

Brilliant: I think when you're using an economic moat lens to look for investment ideas, you're certainly missing the latest highflier or the company that's going to beat next quarter's earnings. It's just not part of what we're looking for. We're looking for those companies that have staying power. So, if you're using a moat analysis, you might identify the next eBay, but you're not necessarily going to identify the next highflier.

Glaser: How do you then use this concept to actually build a portfolio? Do you just buy the companies that you think have the strongest competitive advantages?

Collins: Good question. We're not just looking to buy companies that have these economic moats. We're also looking for companies that trade at sufficient discounts to our estimates of fair value. We look for a sufficient margin of safety before investing.

Brilliant: It really helps improve the potential of future returns to buy something at a discount. For example, if you're looking to buy a house if you can buy it at less than fair market value, you get the appreciation of fair market value as well as the returns that might accrue into the future. And the same holds true with buying very high-quality businesses. If you can buy them at a discount, you really boost your potential to earn excess returns.

Glaser: It sounds like the strategy then is to find these companies with great competitive advantages, wait for their margin of safety, and then buy them.

Collins: You got it.

Brilliant: Sounds good.

Glaser: Elizabeth, Heather, thanks so much for joining me today.

Brilliant: Thanks, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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